Tracking error and ETFs
ETFs are often structured as passive investment vehicles that track indices. For the purpose of benchmarking an ETF, analysts use broad market and market-segment stock and bond indexes. However, performance or returns may vary between the index and the ETF due to various reasons. The difference between the performance of an index and an ETF is called the “tracking error.” Tracking error measures how closely a portfolio follows the index it’s benchmarked to—that is, how well a fund manager replicates the performance of a specific index.
Many ETFs are traditionally passive investment vehicles. So an investor would expect the ETF to mirror the performance of the index. In other words, they would expect the tracking error (the deviation of the ETF from the index) to be zero. However, on various occasions, this may not happen, and the actual returns may underperform the index. For an actively managed fund, the presence of tracking error is obvious, which may result from the fund manager’s efficiency.
In statistical terms, “tracking error” is defined as the standard deviation of a fund’s excess returns. Excess return represents the absolute difference between the fund’s performance and that of its benchmark. A lower tracking error is good for investors because it indicates more consistency in the periodic deviations between the return of the fund and that of its benchmark. On the other hand, higher tracking error is a cause of concern.
So tracking error represents a risk to investors because any divergence of the return of an ETF from the return of a benchmark index represents potential underperformance. The main reasons for tracking error in an ETF are:
- Transactions and rebalancing costs: Analysts have generally observed that over a long period of time, a portfolio’s current asset allocation deviates from the original target asset allocation. This affects an investor’s preferred level of risk exposure. If left unadjusted, the portfolio will either become too risky or too conservative. This calls for the adjustment of portfolio assets or simply rebalancing, which is selling overweight securities and buying underweight securities. Although ETFs don’t often rebalance their portfolios, they sometimes do. And when this happens, ETFs incur various transaction costs like such brokerage commission.
- Sampling: A passively managed ETF that tracks a benchmark containing a number of small illiquid components may use “sampling” techniques to replicate the returns of its reference index. To make buying and selling securities easier in the market, sometimes the ETFs may only select the liquid assets from the basket of securities that the benchmark index holds. While this improves the ETFs’ liquidity, this strategy comes at a cost. The fund could stray from its benchmark by excluding some stocks from the benchmark index, resulting in some tracking error.
- Expenses: Investment in an ETF involves some costs. Funds charge an annual fee or commission to investors for managing the assets. There are called “annual management fees.” The other charges may consist of transaction costs as a result of trading the fund’s assets and performance fees. The performance of the fund is affected by the total expense ratio (or TER), which is calculated by dividing the total annual cost by the fund’s total assets averaged over that year. This ratio varies over the years. An ETF with a TER of 0.85% will underperform its index by 0.85%, all other factors remaining constant, because the theoretical benchmark index will incur any costs.
However, an investor may note that there’s a shortcoming in evaluating an ETF through the measure of tracking error (or TE). TE is a relative performance metric, but it doesn’t capture the actual magnitude of the underperformance or overperformance of an ETF. The alternative to using TE is a method called “tracking difference,” which is the annualized difference between a fund’s actual return and its benchmark return over a specific period. The lower the tracking difference, the better the matching of the ETF with the benchmark index and, therefore, the less the risk for investors.
The largest MLP ETF fund is the Alerian MLP ETF (AMLP), which tracks the Alerian MLP Index, AMZI, a capitalization-weighted composite of 25 energy infrastructure companies. AMLP holds well-known MLP names like Enterprise Products Partners (EPD), Kinder Morgan Partners LP (KMP), and Magellan Midstream Partners LP (MMP). Other MLP ETFs include the Yorkville High Income MLP (YMLP), the Global X MLP ETF (MLPA), the Yorkville High Income Infrastructure MLP ETF (YMLI), and the Global X MLP & Infrastructure ETF (MLPX). Note that these other MLP ETFs have significantly smaller market caps than AMLP.